The parent trap – the risk of liability for a subsidiary’s obligations

20 January 2015

The parent trap – the risk of liability for a subsidiary’s obligations

Introduction

An interim judgment of the Wellington High Court just before Christmas has brought renewed focus on the pooling provisions in the Companies Act 1993.

These provisions, which date back to amendments made in 1980 to the predecessor to the Companies Act, enable a Court to order the pooling of assets of related companies in liquidation and extend to provide scope for a related company to be liable for the debts of a company in liquidation – where it is just and equitable to do so.

Background – pooling provisions

Our company law is firmly grounded in the principle that a company is a separate ‘legal person’. That principle is well-established in case law and is expressly stated in the Companies Act. It follows that shareholders are not generally liable to meet the obligations of the company beyond the extent of their liability to the company for payment of the share capital.

However, the pooling provisions in section 271 of the Companies Act create an exception to that general principle – and were first introduced as a response to cases of well-known public companies that had “abandoned” subsidiaries. It is said that section 271 has been used only rarely and is unique to New Zealand law.

Of particular interest in this case is that section 271(1)(a) allows the Court, if satisfied that it is just and equitable to do so, to order the parent company (or another related company) of a company in liquidation to pay to the liquidators the whole or a part of all or any claims made against the company being liquidated.

The guidelines for such a pooling order are provided by section 272 and direct that the Court must have regard to the following matters:

• the extent to which the related company took part in the management of the company in liquidation:
• the conduct of the related company towards the creditors of the company in liquidation:
• the extent to which the circumstances that gave rise to the liquidation of the company are attributable to the actions of the related company:
• such other matters as the Court thinks fit.

Lewis Holdings – a few details

The background to the orders made in Lewis Holdings was that Stube Industries Limited (“Stube”), a wholly-owned subsidiary of NZX-listed Steel & Tube Holdings Limited, had leased premises from Lewis Holdings (and investment vehicle controlled by interests associated with Sir David Levene). The lease was a perpetually renewable ground lease and, when the then current 21 year term of the lease expired in 2009, it was renewed for a further 21-year term as a result of what appears to have been an oversight caused by the failure to recognise that the terms of the lease provided for an automatic rollover unless a notice of termination was given.

Stube was put into liquidation by a shareholders’ resolution in 2013. The decision to liquidate Stube was made on the basis that the parent should cease providing financial support to Stube after it had made significant but unsuccessful efforts to exit Stube from the lease.

Lewis Holdings filed a $2.62 million proof of debt with the liquidators (a sum calculated as the discounted present value of the loss of its right to future rent under the lease) – and the liquidators sought a Court order under section 271 of the Companies Act, wanting the parent company to pay for Lewis Holdings’ claim in the liquidation.

Basis for the orders

The liquidators were successful in obtaining an order under section 271(1)(a), on the basis that:

• Whilst Stube had a significant property interest, which was both an asset and a liability, there was no evidence of any exercise of management functions concerning that property interest which was independent of the parent company, to any material extent. (This included evidence that the property was treated both as to its benefits and liabilities as something that lay with the parent).
• The evidence about the accounting arrangements supports the proposition that Stube was treated as a division of the parent, for financial purposes. It had no separate bank account. All receipts and payments on its behalf had to be made through the parent’s bank account. Whilst this alone was not found to be determinative – the evidence of the financial intermingling of the affairs of Stube and the parent went well beyond the use of a common bank account. Receipts and payment were not only transacted through the parent’s bank account, they were accounted for as parent transactions.
• The evidence satisfied the Court that the parent company took part in the management of Stube to an extent which was total in all essential respects – Stube was described as a “slave” or “puppet” of the parent, devoid of any capacity to conduct its own affairs.
• The apparent mistake that led to the rollover of the lease was made in the context of the parent’s actions to keep its options open as long as possible, and so not advising Lewis Holdings that it did not intend to renew – which was made in circumstances where the parent (not Stube) obtained external legal advice seemingly without regard to the separate legal existence of Stube.
• In keeping with many subsidiary constitutions – the directors of Stube were allowed to take into account the interests of the parent company (in accordance with the Companies Act).

The Court found that the formal distinction between Stube and its parent was not a distinction which Stube’s directors needed to make on an operational basis. But, as a result of the decision to withdraw financial support and place the company into liquidation, the matter must now be viewed through a different lens. The liabilities of Stube and the parent should have been considered separately.

The Court also noted that the parent, as a publicly listed company with a company solicitor to attend to the legal requirements of itself and its subsidiaries, cannot properly complain to the Court that an order is not just and equitable, by relying on separate legal personality, when for years it has treated itself as a single economic enterprise.

Also, that the constitution of Stube, which enabled the directors to take account of the interests of the parent company, does not operate as what was described in submissions as “a prophylactic against a pooling order”.

Observations

One troubling aspect of the judgment is that its outcome has the appearance of providing the landlord (Lewis Holdings) with a windfall gain in the form of what is effectively a parent company guarantee of the lease. This appears to put Lewis Holdings in the position of obtaining both full rent and the unencumbered use of the property.

The judge rejected submissions on this point on the basis that a pooling order requires consideration of whether it is just and equitable, on the basis of the matters prescribed, that the related company should contribute to the losses of the company in liquidation. In this case, there is a single creditor whose claim is for damages on the disclaimer of the lease. Those circumstances are relevant to the consideration of the factors in section 272 of the Companies Act in deciding whether it is just and equitable to make a pooling order – but the judge decided that the question of whether or not they lead to the same financial outcome as would have applied if there had been a parent guarantee is not relevant.

There then followed a detailed discussion of the difficulties in fixing the measure of Lewis Holdings’ claim in the liquidation – which led the judge to conclude that he should give the parties an opportunity to produce further evidence, and to make further submissions. Consequently, the judgment is interim judgment only.

Pending a finding on the quantum, it is apparent that the discretion provided to the Court by the pooling provisions should not undermine the specific provisions in the Companies Act that enable directors (subject to the constitution of the subsidiary) to have regard to the interests of the parent. In this regard, the judge stated view that section 131(2) provides a limited exception to the duty of directors under section 131(1) – but it is not an exception to any other duty under the Companies Act.

As a result, it follows that even in a group context with the appropriate direction in the subsidiary’s constitution for the directors to have regard to the interests of the parent, because the subsidiary is a separate legal entity – its affairs must be conducted in a way which reflects that separate legal existence. Whilst this inevitably leads to a number of record-keeping obligations, I suggest that the requirement for separate treatment reaches its apex in the context of the liabilities of the subsidiary. Specifically, if there is any indication that (where such support if vital) parent company financial support may be withdrawn or otherwise not available, then it will be incumbent upon the directors of the subsidiary to ensure that the subsidiary’s interests are considered as a separate and distinct entity. This is likely to extend to ensuring that the subsidiary obtains independent legal advice.

A failure to take such steps will create a risk that a Court will apply the pooling provisions under section 271 of the Companies Act – making the parent company liable to pay the liquidator some or all of the claims made in the liquidation of the subsidiary.

Further information

If you would like more information about any of the matters discussed in this note, please contact me.